After a month of calm in July, August has been very bumpy, with nerves rising over the strength of the global economic recovery, a potential change in the Federal Reserve’s policy and capital flight from emerging market economies. They say that one swallow doesn’t make a summer; well a raft of mini-crises certainly ruins ours.
When one adds uncertainty over corporate earnings, the likely outbreak of a worldwide geopolitical event in Syria and seemingly endless flashpoints in the Eurozone to the mix, it is understandable that markets have swooned in the summer sun.
Perhaps the most important place to start is the discussion over diversification, which led to a difficult Q2 for asset allocators. Interestingly the last week or so has seen a resumption of diversification working efficiently and effectively. Perceived low-risk assets, such as core government bonds, gold and investment grade credit have all performed robustly, renewing their credibility as assets to hold when markets are tough. This breakdown in correlations is certainly helpful to all those who, like us, pursue diversification in portfolios. Let’s hope it stays that way.
The global economic recovery
I find it hard to believe that I am about to say this, but clearly the global economic recovery has become even more confusing over the past few months. The US, which was reassuringly strong, has seen some questionable data over the past few weeks, particularly from the housing market. Europe is improving and the UK is undeniably strong at this point in time, which will help compensate for the US slowdown.
Chinese growth has also been more resolute over recent weeks than the bears were roaring it would be, while useful leading indicators, such as Korean exports, have started to gather momentum. Japan has slowed from early Q2 and clearly more help is needed there, which we expect from the Abe administration when the Diet re-opens in September. In short, the economic recovery remains “boring, below-par, bumpy and brittle” but there are still enough positive signs for our forecast that the global economy could return back towards trend growth at some point in 2014.
Change in US monetary policy
The waves of summer volatility were first triggered by the US Federal Reserve’s hints in May that they would start to “taper” their bond purchases (QE) at September’s policy meeting. This in effect “let the cat out of the bag” and global financial markets quickly moved to price in a new trajectory of policy; bonds fell, yields rose, equities wobbled and money started to flow from the EMs and back to the US dollar. If the Federal Reserve messes this up and communicates its path unconvincingly then we could be in for a rocky few years.
The great deceleration in emerging markets
As you will know from previous missives, we have been surprised by how poorly EM assets have performed on a relative and absolute basis over the past year. This has led to plenty of opportunities for long term investors, but patience will be required. Our central view is that investors have swung the sentiment pendulum to negative too aggressively. However, we will be watching on-going developments hawkishly and are ready to act accordingly. It is worth noting that our investments in China have recently recovered very well from their distressed valuation levels at the end of Q2 as the country has (amazingly) become considered a “safe haven”!
The Syria crisis
We always say that it is very hard to prepare investment strategies for events like the unfolding human tragedy in Syria. However, diversification is helping soften the blows that are being caused to markets by the threat of a military strike, as gold, the US Dollar, US Treasury bonds, the oil price and energy company shares have all gained strongly over recent days. If the Syria crisis spirals out of control, which is possible, and creates further shockwaves in the Arab world, then holding the aforementioned assets will be very sensible.
The Never-ending eurozone story
Amazingly, Europe has fallen to 5th in the list of worries that is plaguing investor sentiment, but it is not something we should totally disregard. We are more positive on the wider eurozone growth outlook, as there seems to be a tacit approval of austerity reduction and we believe that Frau Merkel and her coalition will get the victory they desire at next month’s elections. Things are gradually getting better, if admittedly from a low base, and we are seeking to increase our exposure to eurozone equities that are undoubtedly cheap relative to the US.
Equity valuations/corporate earnings
There are definitely question marks appearing about the relaxed attitude of analysts towards US corporate earnings as this year progresses. The last reporting season was “patchy”, with only really the financial sector surprising to the upside. US equities to us look expensive, with the S&P 500 trading on 15xs P/E. We are also concerned about the incessant flow to “safe” US equities and the uniformly optimistic consensus. From a valuation perspective, Europe is much cheaper than the US on 11xs P/E and we believe that earnings in the region should recover in the coming years.
Broadly the same rationale applies to Japan, where we believe that investors are too obsessed with the currency and ignoring the long term earnings growth potential of Japan inc. There is an obvious valuation opportunity in EM equities, as companies across the emerging world are trading at a material discount to the US and other developed markets, ignoring the possible growth of these companies’ earnings.
Our views are contrarian, but we feel confident that value, both from a regional and a sectoral standpoint, will start to work powerfully in the coming years. But now is not the time to be a hero.